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Who Really Sets Interest Rates?

Written by Briton Ryle
Posted June 24, 2019

I have a question. Who really sets interest rates? 

It seems like the answer to this should be a corollary of the golden rule — whoever has the gold makes the rules. 

But there's one problem with that. If the gold owners make all the rules to only benefit themselves and completely ignore the people who are expected to follow the rules, eventually the gold-less will kill the gilded and take all their stuff. It happened in France, it happened in Russia, it happened in Egypt, the 13 colonies eventually rebelled, so did India, South Africa...

Yeah, you gotta throw a bone to the masses every once in a while.

I'm thinking about this because I keep seeing commentary that blames central banks for the current cost of capital. As if the U.S. Federal Reserve Bank truly gets to say rates will be such-and-such percent and then everyone just falls in line and borrows at that rate. 

If you really want to lend money, you have to take into account how much people are willing to pay for a loan. (Free markets tend to do this instinctively. They strike a balance between demand and supply. I would suggest that part of the reason for this is the notion of "free" — that is, in a free market, there's no inherent hierarchy that favors buyer or seller.)

Cost matters. That's why the Fed can hike borrowing costs and slow the economy down. Even a quarter-point changes the calculus, and some people will just say, "No thanks." And if a central bank hits that level, it's instant recession.

Art or Science?

Seems to me the Fed's job is to read the economic tea leaves and divine a specific number for rates — one that encourages growth but avoids inflation. It's honestly unfair to call them economists because that suggests there's a science to it, that an absolute number can be scientifically determined that will create a perfectly balanced economy.

Even a perfect stock still has a bid and ask price. Because the future is always uncertain, and the more uncertain it is, the wider the spreads get. 

It's way easier to just blame the central banks for low interest rates. It's also intellectually lazy, because you're ignoring the demand side of the equation. 

If you think the Fed's screwing it all up, if you think interest rates are way too low, then you have to be able to answer the question: Where's the inflation? 

People will answer that the imbalances have shown up in record levels of corporate debt. And it's true: Companies have borrowed a lot of money and have bought a lot of their own stock. Perhaps as much as a third of average volume these days is companies buying back their own stock. 

That could be a problem when that trading goes away. Because it means liquidity goes away, too, and stocks don't like that. But that doesn't mean it's a bubble.

The Fed Broke Capitalism

If you really want to look for the damage the Fed did by leaving rates too low, look no further than the talking points of the 20 some-odd Democratic presidential candidates. There's a lot of socialism talk these days. And a lot of talk that capitalism is broken.

Both of these developments are the Fed's fault. Capitalism is supposed to be a system that punishes mistakes. Like, if you're an investment bank and put all your eggs in the mortgage-backed security basket and go belly-up, well, there you go. Your business is toast, people lose jobs, etc. It is exactly that punishment that should keep entrepreneurs from taking on too much risk. 

But what did the Fed do in 2008 and 2009? Not only did it not let the most guilty take their medicine, but the Fed actually rewarded the bankers with bailout money that even included bonuses to be paid. 

Now everybody wants theirs.

Seems to me colleges took advantage of guaranteed tuition loans, knowing that 20-somethings aren't going to think about it...

Seems to me health care wouldn't be so expensive if we had true free markets for heath insurance providers...

Should the Fed cut rates in July? Right now, the market is saying yes. Which means stocks will tank if the Fed stands pat. Look, we rallied for a few years while Yellen and then Powell hiked rates. So this isn't a tantrum; it's a message: Growth is weakening and won't support stock valuations for long.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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